In the last three or four years, many people in India have shifted from bank deposits to mutual funds. This did show up as a rise in the assets under management (AUM) with the mutual funds but not as a fall in the level of bank deposits. This is because the deposits merely shift from the accounts of the bank customers to the bank accounts of the mutual funds, and then from there to other bank accounts. This process goes on.
The aggregate bank deposits stay on; these cannot fall even if there is a lower demand in this context! This has become a familiar narrative. While the above narrative can be useful as a starting point, it is not the complete story. And, given the incompleteness, the story can even get misleading. It is important then to complete the story.
This is where we come to some very interesting economics and data. Though in the case under consideration, the level of the deposits does not fall, that level of deposits is on a time path of deposits, and the time path can get relatively flat. In other words, there can be a decline in the rate of growth of deposits.
And, the rate of growth of inflation-adjusted deposits can decline even more, if the inflation rate gets higher than it was previously. But how can all this possibly happen?
Preference shift
Due to a shift in asset preferences, there is an excess of deposits relative to the demand. Next, observe that bank deposits are, by definition, a part of the money in circulation. It follows now that we have excess money in the economy! This is what economists would call excess endogenous money. It arises from within the economy; it has not been issued or induced by the central bank.
However, like an increase in exogenous money, the endogenously created excess money too can be inflationary, if there is no intervention. It is, however, reasonable to expect that the Reserve Bank of India (RBI) would intervene.
How? In the normal course, the RBI keeps on increasing the reserve money (or base money) every now and then to meet the needs of the economy in which the nominal GDP is rising. But given the excess money in circulation within the economy, the RBI can deal with the situation by decreasing the rate of growth of reserve money from outside to deal with the situation.
Given the relationship between the reserve money issued by the RBI, and the money in circulation with the public, the slower expansion of reserve money by the RBI can, in turn, slow down the rate of growth of money in circulation in the economy. And, since money in circulation includes bank deposits, the rate of growth of deposits too can get slowed down on the supply side.
We can return to the main argument now. While the existing bank deposits in the economy cannot fall even though there is a preference shift away from deposits, the additional bank deposits on the supply side can be less than what these would have been otherwise. This helps in adjusting to a relatively lower demand for bank deposits, which is the starting point of the analysis here.
If the RBI adequately decreases the rate of growth of reserve money, and nothing else changes, then the story of adjustment more or less ends there. However, if the RBI does not adequately decrease the rate of growth of reserve money, then obviously there will be some excess money in circulation. And, this can actually lead to higher inflation rate to some extent.
Inflation factor
The higher inflation rate can, in turn, tilt the time path of real deposits downwards. This change in the path of real deposits is the second part of the adjustment to the shift in preferences from banks to mutual funds. The first part of the adjustment, which we saw earlier, is the downward tilt in the path of nominal deposits. It will help to elaborate on how higher inflation can come about. Higher inflation can, under the circumstances considered here, happen in two possible ways.
First, the excess money in circulation can sustain cost-push inflation due to the higher food prices in the economy.
Second, the excess money can cause higher demand-pull inflation; think of “too much money chasing too few goods”. The rate of growth of reserve money has come down from more than 10 per cent to nearly 5 per cent in the last four years.
Even so, the average inflation rate in the last 4-5 years has been more than 1 percentage higher than in the previous few years. All this is still not the complete story. There has been yet another very important development. Currency as a percentage of deposits has fallen from 17 per cent to 15.1 per cent from October 2022 to September 2024.
Relatedly, the money multiplier has risen from 5.2 to 5.6. So, the money supply and bank deposits would, ceteris paribus, rise. But all other things did not remain equal! There was a shift from banks to mutual funds — the main story here. So, there were two counteracting forces — a rise in the path of deposits due to the reduced demand for currency, and a fall in the path of deposits due to a shift from banks to mutual funds. The result is that overall the time path of deposits has actually not shifted substantially and consistently.
The RBI is not responsible for this; it has merely responded to the economic conditions. To conclude, due to a shift in preferences from bank deposits to mutual funds, the level of bank deposits does not fall but the path of bank deposits can adjust downwards in nominal terms and possibly a little more in real terms. This adjustment mechanism has been very much at work but it has been, in practice, countered by some other changes like the demand for currency in the economy.
The writer is an independent economist and former visiting professor, Ashoka University